Pason Systems Inc

TSX:PSI

Earnings Call Transcript 2019-Q3

[Operator]

The contents of today's call are protected by copyright and may not be reproduced without the prior written consent of Pason Systems Inc.Please note the advisory is located at the end of the press release issued by Pason Systems yesterday, which describes forward-looking information. Certain information about the company that is discussed on today's call may constitute forward-looking information. Additional information about Pason Systems, including the risk factors relevant to the company can be found in its annual information form.Ladies and gentlemen, and thank you for standing by, and welcome to the Pason Systems Inc. Third Quarter Results Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions]I would now like to hand the conference over to your speaker today, Marcel Kessler, President and CEO. Please go ahead.

[Marcel Kessler, President, CEO & Director]

Thank you. Good morning and welcome. With me here in Calgary today is Jon Faber, our Chief Financial Officer. I will start with the highlights of the third quarter. Jon will dive into the details of our financial performance, I will close with a brief perspective on the outlook for the industry and for Pason, and we will then take any questions.Pason's operating environment across North America has deteriorated in the third quarter. Industry activity in Canada remains at low levels and decreased a further 37% compared to the previous year.The situation in the United States is also challenging, with drilling activity down 14% driven by the industry-facing pressures from equity and debt investors to constrain spending within cash flows. These headwinds were partially offset by higher activity in Pason's International markets, market share increases in the United States, and continued growth in product penetration in all geographies leading to higher revenue per EDR day.Driving the increase in revenue per EDR day were the higher adoption of data delivery and certain other peripheral products.The company generated revenue of $72.2 million in the period, a decrease of 12% compared to the same quarter last year and essentially unchanged from the second quarter. Adjusted EBITDA was $31.6 million for the quarter, a decrease of 26% and up slightly from the second quarter. Pason reported net income of $15.4 million compared to $24.4 million in the prior year and up from $9.2 million in the second quarter.At September 30, our working capital position stood at $230 million, including cash and short-term investments of $181 million.We are maintaining our quarterly dividend at $0.19 per share.Before turning the call over to Jon for a more detailed look at the financials, I will make a few comments about the 2 recent investments Pason made. These 2 investments provide avenues for us to deploy our distinctive capabilities in 2 additional end markets. In September, we announced the acquisition of a majority interest in -- of Energy Toolbase LLC, or ETB, a private U.S.-based software-as-a-service company for USD 20 million. ETB provides an industry-leading software package to model the economic and build proposals for solar and energy storage projects. The ETB product is utilized by a significant number of distributed energy project developers across the United States. Building on Pason's deep data management expertise, we are combining the capabilities of ETB and Pason Power. Over the last 2 years, Pason Power has been building a foundation in the solar and energy storage market through its iEMS control system and Energy DataHub products. With this investment, we are positioning ourselves for meaningful long-term growth in the solar and energy storage market.In October, we announced a $25 million investment to acquire a minority interest in Intelligent Wellhead Solutions, or IWS. IWS is a privately-owned oilfield technology and service company that provides unique surface control systems for well completions and workover operations. Pason has been looking to enter the completions space for several years and IWS represents the first truly compelling opportunity we have seen where we believe that we can build on our expertise in end-to-end data management and ruggedized field technologies. We are excited to play a role in IWS' continued growth.And I will now turn the call over to Jon.

[Jon Faber, Chief Financial Officer]

Thank you, Marcel. As Marcel noted, industry conditions remained challenging in the third quarter of 2019, with activity levels down in both Canada and the United States. Industry activity was down 14% in the U.S. compared to the third quarter of 2018 and down 37% year-over-year in Canada. Against this backdrop, consolidated revenue decreased by 12% in the third quarter. In the United States, market share increased to 63% and revenue per EDR day increased by 3% to $736 per day.In Canada, we saw revenue for EDR day increase 11% year-over-year to $1,325, while reported market share decreased to 81% in the quarter. Our International business unit reported a 5% increase in revenue for the quarter after accounting for a $1.7 million reduction to revenue as a result of applying hyperinflationary accounting to our results in Argentina.Consolidated revenue in the third quarter totaled $72.2 million and was essentially unchanged from the second quarter.Drilling Data remains our largest revenue category, accounting for 52% of revenue. Growing demand for our data delivery product helps mitigate revenue declines from decreased industry activity in this category. Mud Management & Safety revenue represented 29% of revenue in the quarter. The revenue decrease in the category was less than the overall revenue decrease due to increased adoption of certain peripheral products during the quarter.Communications revenue contributed 7% of revenue in the quarter. Decreases in this category remain the largest among the revenue categories due to changes made to our pricing arrangements in 2019 as a result of adopting new lower-cost technologies to provide service in this space.Drilling Intelligence revenue accounted for 7% of third quarter revenue. Revenue in this category decreased as a result of the overall decrease in North American land drilling activity, with additional headwinds in the United States from rig type and customer mix changes in the quarter.Revenue in our Analytics & Other category contains product and service offerings, which are less closely correlated to drilling activity. As a result, revenue in this category decreased by only 2% year-over-year and represented 5% of total revenue.Adjusted EBITDA for the third quarter of $31.6 million was down 26% from the third quarter of 2018 and up 3% sequentially from the second quarter. On a year-to-date basis, adjusted EBITDA of $102.9 million was down 4% from the first 9 months of 2018, while revenue was up 1% to $227.2 million. Net income of $15.4 million for the third quarter or $0.18 per share was down 37% from the third quarter of 2018 and up 67% sequentially. Net income of $43.7 million or $0.51 per share for the first 9 months of the year was a 4% improvement from 2018 levels.Research & Development and corporate services expenses were relatively unchanged on a sequential basis, while R&D expenses were up 13% year-over-year for the quarter, largely as a result of a shift towards more cloud-based IT infrastructure as we entered the fourth quarter of 2018.Capital expenditures through the first 9 months of 2019 totaled $18.6 million, up 21% from the same period of 2018. Third quarter CapEx of $4.1 million was 16% lower than 2018 levels. We continue to expect to spend up to $30 million on capital expenditures in 2019.Pason generated free cash flow of $33.1 million in the third quarter, up 23% from the third quarter of 2018, and up 2% sequentially driven by a reduction in accounts receivable and lower capital spending.For the first 9 months of the year, free cash flow of $66 million was down $2.9 million from 2018. As a reminder, year-to-date free cash flow includes the negative impact of a $15.3 million payment related to our bilateral advanced pricing arrangement with the CRA and the IRS. We continue to carry an income tax recoverable of $15.3 million related to the offsetting refund due from the IRS once they have completed the reassessment of prior year tax returns.As Marcel noted, during the quarter, we deployed USD 20 million to acquire a majority interest in Energy Toolbase LLC. I'll now turn to a brief review of the results for each of our business units. Our U.S. business unit revenue decreased 8%, or 9% measured in U.S. dollars in the third quarter in the face of a 14% decrease in industry activity. Market share for the quarter of 63% was up both on a year-over-year basis and sequentially from the second quarter.Revenue per EDR day increased 3% year-over-year in the third quarter, in large part from increased adoption of data delivery products in our Drilling Data category and certain peripheral products in our Mud Management & Safety category. For the first 9 months, U.S. revenue of $157.9 million is up 6% from 2018 levels. Operating cost increased 6% year-over-year in the U.S. and 12% on year-to-date basis, reflecting our increased operational capacity in select operating regions.As a result, segment gross profit for the U.S. business unit decreased by 18% to $25.9 million in the third quarter. Gross profit for the 9 months ended September 30 of $84.8 million was up 1% over prior year results. The Canadian business unit managed to again outperform very challenging industry conditions in the third quarter. Pason's revenue for the quarter was 31% lower than 2018, while industry activity was down 37% for the same period. On a year-to-date basis, Pason's 23% revenue decrease compares to a 32% decrease in industry activity.In our second quarter conference call, we indicated that we expected the combination of low drilling activity levels and a greater proportion of cost-focused operators in the active customer mix to result in downward pressure on market share while new products and service offerings would provide support to revenue per EDR day. Reported market share of 81% was down from 85% in the third quarter of 2018, while revenue per EDR day increased 11% in the third quarter and 8% on a year-to-date basis.With drilling activity expected to remain near historically low levels in the upcoming quarters, we expect market share will continue to be more volatile than in years past, owing to the proportionate impact of the gain or loss of any one rig.Sequentially, revenue increased 50%, reflecting the seasonality of Canadian drilling activity. Operating costs were down 12% in Canada in the third quarter and 19% on a year-to-date basis largely as a result of reduced purchasing cost in our Communications category. Segment gross profit for the Canadian business unit of $4.3 million was down 58% from the third quarter of 2018. For the first 9 months of the year, segment gross profit came in at $13 million.Our International business unit saw continued strong performance in the third quarter. Despite a $1.7 million negative impact to revenue as a result of applying hyperinflationary accounting to our Argentina operations, reported third quarter revenue at $8.5 million was up 5% from the third quarter of 2018. Sequentially, International business unit revenue was down $1.5 million as a result of the previously mentioned impact of hyperinflationary accounting. Segment gross profit in the International business unit of $2.9 million was largely unchanged from a year ago.Year-to-date gross profit from the International business unit stood at $9.3 million, up 78% from 2018 levels. In summary, Pason's third quarter results represent continued outperformance in the context of challenging industry conditions. We are defending our competitive position while seeking opportunities to grow revenue per EDR day through delivering enhanced functionality to our customers. We continue to prudently manage our costs with a view to sustaining our profitability without impairing our ability to fully participate when industry conditions improve.Our balance sheet remains strong. At September 30, prior to the investment in Intelligent Wellhead Systems, we had $230 million of working capital, including $181 million of cash and no interest-bearing debt. We are returning cash to shareholders through our regular dividend and our normal course issuer bid program. Through the first 9 months of the year, we paid in aggregate, $47 million in dividends, and we are maintaining our quarterly dividend at $0.19 per share.We deployed a further $13 million in the first 9 months to order a normal course issuer bid, more than offsetting the effects of dilution from stock option exercises in the trailing 12-month period.And I will now turn the call back to Marcel for his comments on our outlook.

[Marcel Kessler, President, CEO & Director]

Thank you, Jon. With drilling activity levels declining and operators maintaining discipline about spending levels, visibility remains quite poor with respect to operator budgets as we move into 2020. There is a chance that rig counts will bottom in the fourth quarter but they may stay low for some time. However, we believe that there are good reasons for optimism regarding drilling activity in the medium term.Demand for oil continues to increase each year. Consumption of oil-based products has gone from 75 million barrels per day in 1999 to over 100 million barrels per day this year.The industry needs to add more than 1 million barrels per day of new supply each year. The world relies on hydrocarbons and there is nothing on the horizon that can replace it. Fears that the trade war between the U.S. and China will significantly reduce oil demand seem overblown and the International Energy Agency has reduced their oil demand forecast by only 100,000 barrels per day. It is not possible for U.S. oil production to keep increasing or even stay flat if drilling activity is low and dropping. Oil prices need to go higher at some point to avoid a supply shortage and drilling activity will follow.In this environment, we are keeping our fixed costs low and maintaining flexibility for our go-forward plans, which gives us the means and confidence to address any activity scenario. We do not plan to reduce our R&D efforts. Our capital expenditures will be relatively modest going forward with a large portion of development efforts focused on software. We expect to -- we expect capital spending levels to be up to $25 million in 2020.Our highly capable and flexible IT and Communications platform can host additional new Pason and third-party software at the rig site and in the cloud. Our market positions remain strong, and we expect to be able to deliver growth in our International markets and through higher product adoption going forward.Finally, we wanted to highlight that the timing of the 2 recent investments close to each other was coincidental. We had been investigating opportunities to make an investment in the completions space as well as to accelerate our efforts in the solar and energy storage market for some time. There are no additional investments planned in the short term in either area. However, we will continue to scan the drilling completions and power markets for attractive long-term growth opportunities.We will now be happy to take any questions.

[Operator]

[Operator Instructions] First question comes from Greg Colman with National Bank Financial.

[Greg R. Colman]

Just wanted to start by talking a little bit about the outlook. Marcel, I would agree entirely that in the medium term, the rig count trajectory and oil production trajectory are mutually unsustainable in the medium term. But in the short term, our view is that the role of the U.S. rig count is likely to continue. And your guidance looking into at least early 2020 would be cautious as well. I'd like to talk about your cost structure in the current environment versus previous environments when we've seen your revenue roll. Is there any reason that if 2020 should be a down year from a revenue perspective, that there is overall change in the way EBITDA margins react in this cycle versus previous given the change in your cost structure, operational efficiencies and adoption of some complementary products?

[Marcel Kessler, President, CEO & Director]

Greg, I will actually let Jon take that question.

[Jon Faber, Chief Financial Officer]

Sure. Greg, I think if you look back a few years when we came into the downturn late 2014 into 2015, as you know, we made a number of changes to the cost structure, reduced a number of fixed costs, made some other costs more variable. We've done a very good job, I think, since then, not bringing a lot of those costs back. So I think our cost structure, we feel quite comfortable with today. And Marcel indicated, we certainly wouldn't anticipate making any reductions on the R&D side. On the operational side, I think it's very important for us to maintain our capacity to respond as things get better into the medium term.So we tend to look at this with more of a 2-year to 3-year outlook on where we think activity may go rather than a response to the 1-year expectations and I think our cost structure is quite appropriate today. So if revenue were to go down into 2020 as a result of activity slowing, I think you would see some more compression on the EBITDA margin side as a result of that. I just don't think we'll be as responsive on the cost side.

[Greg R. Colman]

Got it. So the EBITDA margin compression we've seen in the past would be indicative of what we would see if we -- if revenue was to roll. There's no reason for it to be materially different than in sort of this cycle than what we've seen in previous downturns?

[Jon Faber, Chief Financial Officer]

That would be correct.

[Greg R. Colman]

Got it. Just keeping on unfortunately sort of negative view topic here. If industry activities do deteriorate, say, more significantly than anyone's looking in 2020, would you be comfortable using your cash balance to temporarily support the dividend throughout periods of negative free cash flow, say, 1, 2, 3 quarters? Or would you look to defend the balance sheet and in periods of negative free cash flow, look to change the dividend policy?

[Marcel Kessler, President, CEO & Director]

No. I think the short answer is, yes. We will look to defend the dividend.

[Greg R. Colman]

Got it. And then moving on to International markets, a little bit more positive note, you mentioned that there's a bit of lone in bright spot in Q3. Would you expect that to continue based on the visibility you see on those customers which just -- based on their location are a little bit tougher for us to look into even given the challenging sort of commodity environment at the moment. Is double-digit top line growth for the International segment unrealistic? Or is it within reach?

[Marcel Kessler, President, CEO & Director]

I don't think it's realistic looking forward, especially given the importance of Argentina in our International portfolio. The recent elections in Argentina have created some uncertainty and probably negative pressure in drilling activity there in the short term. So I do not expect to continue the growth that we have seen here over the last year or 2.

[Operator]

Next question comes from Daine Biluk with CIBC Capital Markets.

[Daine Biluk, Associate]

So, nice to see some market share gains in the U.S. Was that a function of an incremental customer win? Or was it largely just core clients remaining more active through the quarter?

[Marcel Kessler, President, CEO & Director]

It was a mix of both. I think increased penetration with one of our largest customers and activity levels between operators but slightly tilting in our favor, both played a role.

[Daine Biluk, Associate]

Okay. Got you. And maybe just staying on the U.S. and kind of related, I mean, a small decline in revenue per EDR day sequentially. Could you maybe just elaborate on the moving pieces behind that?

[Marcel Kessler, President, CEO & Director]

So with the revenue per EDR day, there's a couple of things at play. Any time we get into a slowdown in the overall industry, customers become a little bit more cautious and look for opportunities to reduce cost where they can. So that would have resulted in slightly lower adoption on some of the peripheral products. And then to your earlier question around just the mix of active customers, there are certain customers where the revenue opportunities are different based on the profile of their rigs or profiles of arrangements we might have with them on technology, arrangements, et cetera.So sometimes those customers that are active, the revenue opportunity isn't quite the same and that can put some pressure on revenue per EDR day as well. If the customer that we accrue a little bit less revenue is more active.

[Daine Biluk, Associate]

Got you. Okay. That's very helpful. And again with those customers that are maybe dropping some of the peripheral products, it's more a function of them just trying to save cost and not them taking maybe a competitors and bolting it on or anything like that, correct?

[Marcel Kessler, President, CEO & Director]

Correct. If it was a customer going through a competitor, that would show up as market share.So it's a case of refusing some of the peripherals when it shows up in revenue per EDR day.

[Daine Biluk, Associate]

Perfect. Okay. Moving on internationally. Can you give us a bit of an update specific to the Australian market and outlook for 2020? Obviously, it's been one of your guy's stronger areas but any expectations for that to be more moderate growth rate going forward? Whether that be activity on a -- or on a product adoption side?

[Marcel Kessler, President, CEO & Director]

Based on what we see today, we expect the Australian market and our activity there to stay at the current high levels and to be able to maintain the currently high margins. But I don't think that we'll see the steep growth trajectory we have seen over the last couple of years.

[Operator]

[Operator Instructions] And we have a question from Ian Gillies with GMP.

[Ian Brooks Gillies]

The changes in rig count by basin have obviously been quite differentiated. Can you provide a bit of an update of where you're at or where you may be stronger in certain basins rather than other basins? Just -- because that's the other part that's obviously going to be -- obviously play a big part in market share is we go through year-end.

[Marcel Kessler, President, CEO & Director]

Good question. I'm going to focus primarily on the U.S. in my comments here, Ian. So...

[Ian Brooks Gillies]

Yes. I was going to say specifically to the U.S., my bad.

[Marcel Kessler, President, CEO & Director]

Right. So yes, the activity declines in the U.S. across basins has been highly uneven. I think leading the losses has been the mid-continent. So the Oklahoma area, the Bakken wasn't great either. There were some declines on the Permian but much less than the rest of the U.S. And this actually aligns quite nicely with our area of strength and market share. So the mid-con has long been our weaker areas so the relative declines there have been hurting us less so to speak. And the Permian capability and market share has been above average, at least, in more recent times. So that's really -- it's been in our favor a bit.

[Ian Brooks Gillies]

If I go back in history and this number may be dated, I remember there was a ratio of field employees per rigs you like to have whether it be in Canada or in the U.S. I believe it was for every 3 rigs you wanted 1 field employee. Has this -- has that metric changed at all over the course of time with pad development? Or have you seen any changes there that helped the cost structure per say?

[Marcel Kessler, President, CEO & Director]

So I think that ratio never had been 3:1, I think it was always closer at least as a target to 8 to 10 to 1. So 1 field tech taking care of 8 to 10 rigs. It has not fundamentally changed with the move from 2, 2 pads. But there is quite a bit of variability across the different basins given how quickly activity levels have changed.

[Ian Brooks Gillies]

Okay. And with respect to the acquisitions that were made, I'm going to work under the assumption that you see a number of opportunities given the strength of the balance sheet. Was there something different about these opportunities if they are scaled to a certain size, that provides a certain financial benefit relative to some other opportunities you may see? Or, I guess, what was the difference with these acquisitions once commerciality may be reached or more scale?

[Marcel Kessler, President, CEO & Director]

So the key factor for us when considering acquisition has always been our conviction that we're able to value the -- add value to the assets we acquire. And so talking about the completion phase first, we have been looking to enter certain aspects of the completions space around data managed for several years.We never really found a compelling asset or business where we thought, no, we really understand what they are trying to do. We really understand how we could help them. IWS was the first thing we really saw that was compelling and we felt, there's really something around the end-to-end data management aspect of this as well as our expertise in designing, deploying and servicing the ruggedized field technology.And to your question, where we could really see that, it could be material in terms of the overall magnitude of the opportunity a few years out. So if we achieve some kind of penetration of the active completion fracking fleet with that service, it can be material to Pason in the medium to longer term.Similarly on Pason Power, that's obviously a longer-term play. It's a broader step out. The lens here around we have to be able -- we have to be convinced that based on our experience, our expertise, we can add value, that was still crucial. And we felt that the combination of ETB and Pason Power really felt quite unique in terms of what it can achieve together.Now I don't want to create any expectations around the contribution here in 2020 or '21, it is a longer-term play. But the hurdle and the length has always been our ability to add value to what we buy, and then obviously the magnitude of the opportunity in the medium term has to be substantial.

[Operator]

[Operator Instructions] And we have a question from Vincent [ Lavoie ] with Journey 103 News.

[Unknown Analyst]

I have 3 questions for you. The first one is how could the Alberta's budget affect your business in the near future?

[Jon Faber, Chief Financial Officer]

I think when you look at the budget, there's obviously a lot of things in there. The one area that specifically probably has an impact to Pason just given we have a fairly reasonable sized R&D presence is some of the changes that they would've made to the SRED credits, the Scientific Research & Development credits, which -- that going away would have a little bit of a negative impact to us on a cash taxes basis. But that's probably the only one that I would call out as having a specific impact to us. And again, that's just given we have more of a technology angle.

[Marcel Kessler, President, CEO & Director]

But overall nothing material. Nothing material.

[Jon Faber, Chief Financial Officer]

Nothing material. Yes.

[Unknown Analyst]

Okay. And my second question, how do you feel towards companies like Houston Oil and Gas going out of business in Alberta?

[Marcel Kessler, President, CEO & Director]

I didn't catch the question.

[Jon Faber, Chief Financial Officer]

The question was, how do we feel about smaller companies going out of business in Alberta?I think, we, like all Albertans and all Canadians, right? It's challenging to see any company, customer have a tough time in this environment. So...

[Unknown Analyst]

Okay. And if 2020 is going to be a down year revenue wise for your company, what measures would you -- would your company use to encounter such financial issues?

[Jon Faber, Chief Financial Officer]

Vincent, again, I just want to turn back to a question we were asked a couple of questioners ago around, our costs tend to be somewhat fixed, and we tend to take a medium-term view on these things. And so I think the implications for us if revenue was down is that earnings would be down, but that we wouldn't be quite as responsive in terms of the cost side.

[Operator]

[Operator Instructions] And we do not have any phone questions at this time. I will turn the call over to the presenters.

[Marcel Kessler, President, CEO & Director]

Well, thank you, everybody. Have a great day.

[Operator]

This concludes today's conference call. Thank you for participating. You may now disconnect.